Lecture 10 Notes PDF

Preview

Summary

Lecture 10 Notes...

Description

THE FINANCIAL SYSTEM / 25556 10. THE FUTURES MARKET (BAB and SPI Futures) LEARNING OBJECTIVES [CHAPTER 13] o Explain the risk-transfer and price-discovery functions performed by the futures market o Explain the trading and settlement arrangements used by the ASX in providing a platform to trade futures contracts o Describe bank-accepted bill (BAB) futures contracts and show how they can be used to hedge the interest-rate risks faced by borrowers and lenders o Describe the 30-day interbank cash rate and three- and 10-year bond and share price index (SPI) futures contracts, and explain how these can be used for hedging purposes

10.1. INTRODUCTION TO FUTURES CONTRACTS x

Another derivative contract that can be utilised to manage risk

Futures Contracts: A contract to buy a specific quantity of a commodity or financial instrument at a specified price with delivery set at a specified time in the future x

How do futures differ from other contracts? 1. The futures markets decides the items that can be traded 2. They have a future settlement date (and so are similar to forward contracts) 3. Most are cash settled, rather than settled by the exchange of the contract item 4. Futures contracts can be closed-out by an offsetting trade before their settlement date

10.1.1. CONTRACT SPECIFICATIONS 1. The item being traded, with the available items decided by the exchange o For example – commodities, such as wheat, or financial instruments, such as BABs or bonds 2. The future settlement date o Such as the 2nd Friday in September 3. How the contract can be settled o By the delivery of the contract item or by cash 4. The settlement price agreed between the buyer and seller of the futures contract

10.1.2. LONG & SHORT POSITIONS x

Futures contracts can be traded before their settlement date allowing the traders to avoid the contract’s obligations and instead cash settle the contract

100

THE FINANCIAL SYSTEM / 25556

x

Example – Wheat Futures o One wheat futures contract is for 20 tonnes of wheat o Say the wheat futures contract with a settlement date of June 2018 is currently traded for $229 per tonne o A contract is formed when a buy order and a sell order are matched, for example:

101

THE FINANCIAL SYSTEM / 25556

102

THE FINANCIAL SYSTEM / 25556 10.1.3. CASH SETTLEMENT x x x x

Deliverable contracts can be settled by an exchange of the contract item for the agreed price A trader can close-out their position at any time prior to the settlement date Even most deliverable contracts are cash settled Cash settlement overcomes the need for the futures market to arrange physical settlement

x

A trader can close-out their position at any time prior to the settlement date by taking an offsetting position in the same contract o Results in a profit or loss which is the difference between the selling and buying value Even most deliverable contracts are cash settled Cash settlement overcomes the need for the futures market to arrange physical settlement

x x

10.2. THE ROLE OF THE FUTURES MARKET 1. The risk-transfer function 2. The price discovery function

10.2.1. THE RISK-TRANSFER FUNCTION x

x x

Futures markets were first established to manage the risk associated with volatile agricultural commodity prices o Which posed risks for both buyers and sellers Financial futures were introduced to manage the risk posed by volatile financial variables o Including interest-rates, exchange-rates and share prices Futures markets are also attractive to speculators

A HEDGING EXAMPLE A wheat farmer is exposed to the risk of an unexpected fall in future wheat spot prices. They can hedge this risk now by selling wheat futures. [Probably settled by a cash payment (+ or -) that offsets the change in the spot price at which wheat is sold in the physical market] Likewise, a flour mill is exposed to the risk of an unexpected increase in the wheat price. They can hedge this risk now by buying wheat futures.

103

THE FINANCIAL SYSTEM / 25556 10.2.2. THE PRICE DISCOVERY FUNCTION x

x

Futures markets perform price discovery (by establishing forward prices) as long as the contracts are actively traded o Not all futures contracts are liquid o Trading volumes for BAB, SPI, 3 year and 10-year Treasury bond futures are very large, and can be interpreted as revealing forward prices For example, the forward yields revealed by BAB futures trading are used by FRA and interest-rate swap dealers

LIQUIDITY x High liquidity in financial futures is a result of: 1. The very low cost of trading contracts The futures contracts themselves are free Out-of-pocket expenses include margin payments (discussed later) and brokers’ commissions (that are tiny relative to the value of the contracts) 2. A limited amount of settlement dates 3. Standardised contracts

10.3. SPI FUTURES CONTRACT x

The specifications of the SPI futures contract:

x

The long position:

104

THE FINANCIAL SYSTEM / 25556 x

The short position:

10.3.1. USES OF SPI FUTURES x x x

The contracts can hedge the risk of a fall in the index through a short position in SPI futures If the index falls the futures are closed-out at a profit and this protects the portfolio’s value Speculators can profit if they are able to correctly predict an increase or decrease in the value of the index, but risk making a loss if they are wrong

EXAMPLE – SPI FUTURES FOR SPECULATIONS x Calculate the profit or loss associated with a long position in ten SPI futures contracts entered at 4931 and closed out at 4885.

x

Recalculate if the close-out transaction was at 5000.

EXAMPLE – SPI FUTURES FOR HEDGING x In May an equity portfolio manager forecasts that there will be a significant decrease in the ASX200 by September. The value of the portfolio is currently $55 million and in May the September SPI futures are trading at 5500. x

How the manager can hedge the risk of lower share prices? o In May, given that the portfolio is worth $55 million, the manager would take a short position in:

105

THE FINANCIAL SYSTEM / 25556 x

How does this hedge the value of the portfolio if the index falls to 5150 in September? o In September, the index falls to 5150. This means the value of the portfolio has fallen; however, this will be offset by the profit that results on the futures position:

o

Combined, the value of the portfolio has been successfully maintained at $55 million despite the drop in the value of the index.

10.4. BAB FUTURES CONTRACTS x

The specifications of a BAB futures contract:

x

BAB price vs BAB value

106

THE FINANCIAL SYSTEM / 25556 x

BAB futures – The long position

x

BAB futures – The short position

10.4.1. BAB FUTURES AS A HEDGE INSTRUMENT x x

Issuers of BABs are exposed to the risk of higher than expected rates BAB futures can be used to create an offsetting position to hedge the exposure by: o Selling BAB futures now o Closing-out the futures position (by buying the same BAB futures) at the same time as the BABs are sold in the money market This generates a profit or loss that offsets the outcome in the money market

ILLUSTRATION Say a company plans to issue $6mil in BABs in December. If it is now November, how can it hedge the risk of higher rates using BAB futures? -

December BAB futures are trading at 93.30 It turns out the interest rate in December is 6.9% (and the futures price is 93.10)

107

THE FINANCIAL SYSTEM / 25556

10.4.2. THE HEDGE PAYMENT 1. The profit or loss on the futures contracts:

2. The proceeds from the sale of bills in the money market:

OUTCOME OF HEDGE 3. The borrower’s effective rate is the combination of the money market proceeds and futures market profit/loss:

10.4.3. HEDGING WITH BAB FUTURES x x

The interest rate exposure of a bill facility can be managed through a strip hedge o Consecutive BAB futures contracts Acceptance fees will add to the borrower’s forward rate

108

THE FINANCIAL SYSTEM / 25556 10.4.4. BASIS RISK

10.4.5. COMPARING BABs AND FRAs x x

x

BAB futures and FRAs can perform the same hedging purpose The main differences between them are: o BABs futures are standardised contracts whereas FRAs meet the client’s specification, hence FRAs generally are more precise hedges o BAB futures are traded whereas FRAs do not have a secondary market, hence a BAB futures hedge can be easily terminated The BAB futures market is perhaps more important because it is the forward interest rate market

10.4.6. PRICE DISCOVERY BY FUTURES MARKETS

109

THE FINANCIAL SYSTEM / 25556 10.5. THE ASX FUTURES MARKET x x x

Previously known as the Sydney Futures Exchange, the ASX now conducts Australia’s futures market and enforces trading rules to ensure the market is fair and orderly The SFE was established in 1960 as a market for wool futures Since deregulation, trading in financial futures have dominated, particularly:

10.5.1. FUTURES CONTRACTS x

The ASX futures market specifies the contracts in terms of:

10.5.2. TRADING SYSTEM x x x x

The ASX provides an automated trading system (called ASX Trade 24) into which orders are submitted by brokers or their on-line trader clients Trading is conducted on a 24-hour basis – divided into a day and a night session No distinction between primary and secondary market, contracts trade until their contract date at which time all open positions must be settled The market’s clearinghouse organises the settlement of trades and their mandatory closeout

110

THE FINANCIAL SYSTEM / 25556 10.5.3. THE CLEARINGHOUSE x x

ASX Clear (Futures) clears and settles transactions It also managed default risk through: 1. The novation of trades – the clearinghouse is counterparty to each transaction (sells to the buyer and buys from the seller), This means every trader has obligations only to the clearinghouse 2. A system of margin payments

INITIAL MARGINS x The clearinghouse ensures it always has sufficient funds from the losing position to pay the winning position x Initial margins are required from both the buyer and seller when a position is first traded to open their margin accounts o The amount varies between contracts and in response to recent volatility to ensure it is sufficient to cover the maximum loss likely in one day

DAILY RESETTLEMENT x Further daily margin payments are required from the losing side when the balance in its margin account falls below the maintenance level o This is marking-to-market o Otherwise the clearinghouse will close-out the position x ‘Winners’ receive their margin payments back and for holders of losing contracts the payments meet the cash settlement

10.5.4. FUTURES MARKETS PARTICIPANTS

x

Traders like the market’s low costs and high liquidity

111...